Policy Research
WORKING PAPERS
Financlal Policy and Systems
Country Economics Department
The World Bank
October 1992
WPS 984
Barriers to Portfolio
Investments in Emerging
Stock Markets
Asli Demirguq-Kunt
and
Harry Huizinga
The capital gains withholding tax levied on foreign portfolio
investors increases required pre-tax rates of return in developing
countries, increasing domestic firms cost of capital and discour-
aging physical investment. Dividend withholding taxes do not
have this effect since foreign investors can obtain offsetting tax
credits.
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not be attributed to the World Bank, its Board of Directors. its managemnent. or any of its member countries.
Policy Research|
Financial Policy and Systems
WPS 984
This paper- a product of the Financial Policy and Systems Division, Country Economics Departuent-
is part ofalargereffort inthe Department to understand the impactofemergingstockmarkets in developing
countries. Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington
DC 20433. Please contact W. Patrawimolpon, room N9-043, extension 37664 (October 1992, 27 pages).
Demirguic-Kunt and Huizinga examine to what the 1980s. The cost of equity finance in develop-
extent features of the intemational tax system ing couitxies has gained in importance in the last
and indicators of transaction costs affect the decade, as these countries' access to international
required rates of return on emerging stock lending capital has been limited during most of
markets. the decade.
They show that the capital gains withholding What do these findings imply for the design
tax levied on foreign portfolio investors in- of tax policy in relation to foreign portfolio
creases required pre-tax rates of retum. As investmnent in developing countries? The exist-
countries generally do not index their capital ence of foreign tax credits for dividend taxes
gains taxes, it follows that inflation increases the paid suggests that a country should tax capital
capital gains tax base, as well as the required rate gains more lightly than repatriated dividends -
of return on equity. as do Greece, Pakistan, Portugal, and Venezuela.
Dividend withholding taxes instead appear Each of these countries has positive-dividend
a1ot to increase the required pre-tax equity returns withholding taxes but no capital gains taxes
significantly. The differing results for capital imposed on nonresidents. Colombia and India do
gains and dividend taxes reflect the fact that the exact opposite: they tax capital gains far
foreign investors generaUy can receive domestic more heavily than dividends. Despite what
tax credits only for foreign withholding taxes appears optimal, the trend in developing coun-
paid on dividends. tries is toward lower dividend withholding taxes,
The return on equity is part of the issuing with little change in the average level of capital
firm's cost of capital. So, capital gains withhold- gains taxation.
ing taxes imposed on nonresidents increase the It also appears desirable for developing
cost of capital for domestic firms and discourage countries to index their capital gains taxes to
physical investment Private investment levels prevent them from being higher than anticipated.
have tended to be low in developing countries in
ThePolicy ResearchWorking PaperSeriesdisseminates the fmdings of work under way in the Bank. Anobjectiveof the series
is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and
conclusions in these papers do not necessarily represent official Bank policy.
Produced by the Policy Research Dissemination Center
BARRIERS TO PORTFOLIO INVESTMENTS IN
EMERGING STOCK MARKETS
Asli Demirgui-Kunt
The World Bank
and
Harry Huizinga*
Stanford University
July 1992
*This paper was written while the second author was a consultant in the Financial Policy and Systems Division
of the World Bank.
Table of Contents
I. Introduction 1
II. The Model 4
III. The Data 9
IV. Empirical results 11
V. Conclusion 15
References 18
Endnotes 20
Annex Tables 21
1. Introduction
If international capital markets are integrated then assets with equal distributions of returns in
a particular currency should trade at the same price. The tendency of investors worldwide to hold
primarily domestic securities, however, suggests that there exists significant barriers to international
capital mobility. The presence of imperfect international capital markets has the important implication
that the cost of equity finance depends on where the capital is raised.
A barrier to development in many developing countries in the 1980s has been inadequate
levels of business investment. To the extent firms finance their marginal investment projects through
the stock market, stock market performance influences investment incentives. Private sector
investment will be low if required rates of return on equity are rather high, which are part of the
overall cost of capital of the firm.
Singh et al. (1992) report that in developing countries corporations rely to a greater degree on
external finance than firms in the developed world, and that equity finance plays a more central role
in the growth of these corporations. For example, the median Korean company in their sample of top
50 manufacturing firms financed more than 40 percent of its growth from equity issues in the 1980s;
the corresponding figure for the median Mexican corporation was over 75 percent and for the median
corporation in Jordan over 80 percent. Dailami (1990) further documents a statistically significant
correlation between stock market price movements and aggregate corporate real investment in Korea,
although he finds no strong relationship between earnings and investment.
Black (1974) and Stulz (1981) model barriers to international portfolio investment as
proportional taxes on foreign asset holdings. Black (1974) assumes the tax rate is positive for long
positions and negative for short positions, while Stulz (1981) instead assumes a positive tax applies
equally to all positions. Booth (1987) further examines how the differential taxation of dividends
accruing to domestic and foreign residents affects the international ownership of equity capital. As an
alternative to the characterization of capital controls as taxes, Eun and Janakiramanan (1986), Errunza
and Losq (1989) and Hietala (1989) model investment barriers as prohibitions on particular cross-
ownerships of assets.
Empirical work on international capital barriers has generally not relied on an iderntification of
which barriers are in existence and how they should be expected to affect asset returns. Instead a
general approach has been to construct an international asset pricing model for the case of perfect
capital markets, and tLien to test the restrictions of the model implied by international capital market
integration. A rejection of these restrictions is taken as evidence of international market
imperfections. Examples of this literature are Stehle (1977), Jorion and Schwartz (1986), Cho, Eun
and Senbet (1986), and Wheatley (1988).
Even when specific investment barriers are identified, empirical testing of the impact of these
barriers on international asset pricing has proven difficult, as it is difficult to incorporate the cost-
equivalents of the range of international capital barriers into asset pricing models. The investment
restrictions considered by Cho, Eun and Senbet (1986), Bosner-Neal, Brauer, Neal and Wheatley
(1990), and Gultekin, Gultekin and Penati (1989), for instance, do not allow for a straightforward
computation of tax or transaction cost equivalents. These authors instead examine how changes in the
investment restrictions differentially affect the international pricing of assets and of risk.
This paper examines the role of (i) taxation and of (ii) proxies for other investment-related
costs that affect stock market performance of developing countries. The paper first shows that
differences in the national taxation of foreign portfolio investment significantly affect stock market
returns. Second, it shows that the ratio of a country's stock ma,ket capitalization to GDP is a good
indicator of other costs of portfolio investment in a certain country.
As in the original work of Black (1974) and Stulz (1981), investment barriers that take the
form of taxes can be explicitly incorporated in an asset pricing model, and it is straightforward to see
2
how pre-tax returns on equity increase with any withholding taxes levied by the developing country.
Hence, asset pricing for the case of perfect capital markets as well as its alternative are well specified.
Proxies that capture direct transaction costs are also easily incorporated. The study examines stock
market returns for 18 developing countries with emerging equity markets. The data is from the
Emerging Markets Data Base constructed by the International Finance Corporation.
The extent to which withholding taxes affect pre-tax equity returns depends in part on whether
foreign investors can obtain tax relief in the form of a tax credit or deduction from their national tax
authorities. The developed countries, including the United States, generally provide tax relief in the
form of a tax credit or deduction only for foreign dividend taxes. Hence, the withholding tax on
foreign capital gains taxes tends to be a final tax that is fully borne by the foreign investor. To
compensate the investor the pre-tax rate of return has to rise accordingly.
The main result of this paper is that capital gains taxes imposed on foreign residents increase
the required pre-tax rates of return, while withholding taxes on dividends do not. Most countries do
not index their capital gains taxes to adjust for inflation. Thus inflation by itself increases the capital
gains tax base, and the necessary pre-tax rate of return on equity. This paper shows that the taxation
of purely infationary capital gains indeed has an independent positive impact on the required rate of
return on equity in emerging stock markets. The capital gains tax burden related to inflation are in
addition to any other inflation costs borne by the private sector.
The remainder of this paper is organized as follows. Section 2 sets out a version of the mean-
variance international asset pricing model that includes dividend and capital gains witholding taxes.
Section 3 describes the data, while section 4 presents the empirical results. Section 5 concludes by
discussing the implications of the paper for investment and for taxation policy in developing
countries.
3
2. The model
The model takes the perspective of a U.S. private or institutional investor. The investor can
invest freely ifi the U.S. and foreign developed and developing country equity markets. In addition,
the investor can borrow and lend at the risk-free dollar interest rate R. There are no international
investment barriers other than the domestiz and foreign taxation of the returns to international equity
inve, tments. The U.S. investor is assumed to be invested in a number of developing country
emerging stock markets. A differential rate of taxation of domestic and foreign equity returns will
then give rise to different pre-tax rates of return for foreign and domestic assets with perfectly
correlated returns in a common currency. This section incorporates several features of the double
taxation of foreign equity returns in the mean-variance asset pricing model originated by Sharpe
(1964) and Lintner (1965). The presence of double taxation gives rise to the addition of several tax
burden terms in the mean-variance capital asset pricing equation. An empirical significance of any of
these terms implies the presence of tax barriers to international capital market integration. Empirical
tests of the model are presented in section 4.
The U.S. investor's foreign equity returns are first taxed abroad. In particular, country i
taxes the U.S. investor's dividends at a rate 4d, while capital gains, measured in local currency, are
taxed at a rate 4. For purposes of assessing the capital gains tax burden, it is assumed that capital
gains are realized each period.' In addition to foreign taxes, the investor is subject to a U.S.
personal (or corporate) income tax at a rate v,,. Interest income is taxable in the U.S., while interest
expenses are fully deductible from U.S. taxable income.2 Finally, the U.S. investor generally can
claim a U.S. tax credit for foreign taxes paid to lessen the burden of double taxation. U.S. (and
other developed country) foreign tax credits tend to be limited to foreign dividend taxes, and even
there several limitations apply.3 Generally let yc and Yd be the shares of foreign capital gains and
dividend taxes paid that are eligible for a U.S. credit. 0,=1 -y, and Od"1-Yd then are the incidences
4
of the foreign capital gains tax and dividend taxes on U.S. investor - for a given pre-tax rate of
return. For a small country that faces a perfectly elastic demand for its securities, the pre-tax rate of
return on equity then has to rise by the incidence rates times the assessed capital gains and dividend
tax burdens to compensate the foreign investor. For this case, the incidence of any foreign taxes on
the U.S. investor ultimately lies with the U.S. Treasury or the foreign country itself.
Apart from taxes, differences in international transaction costs can give rise to differences in net
equity returns across countries. Let cl denote the dollar transactions costs per dollar invested in
market i per period. The transaction cost can be a brokerage fee or other costs such as legal costs
necessary to protect the investor's assets. Differences in transactions costs may hence reflect
differences in legal or accounting rules. The starting point of the analysis is the following standard
capital asset pricing relationship
ERi- -R= (XR(E -R) (
where ERi is the expected dollar return on equity in counts) i after all taxes and transaction costs'
z is the expected dollar return from the world portfolio which includes all countries'
equities in proportion to their market values after all taxes and transaction costs.
The foreign country assesses taxes separately on capital gains in local currency and on
dividends. Let us use CL1 and DY1 to denote the parts of the U.S. investor's dollar return that are
subject to the foreign country's capital gains and dividend taxation. CL1 and DYr are given as follows:
CL= ( xi,)- 1) (2)
5
D1 i - i ti 6-1 X 4
DYI= DI e1i (3)
where II is the local currency price index of equity market i
el is the exchange rate measured as the dollar price of one unit of foreign currency
Di are local currency dividends paid in market i during the period.
Note that in case of a dollar appreciation, i.e. e< 'el, , CL1 can be positive, even if the
dollar price index remains unchanged or even falls. The capital gains and dividend tax base variables CL1
and DY1 are assumed to be random variables with means ECLi and RDY1 and random terms ea and
ed' respectively.
Taking into account the various aspects of the tax system and transaction costs, we can now
express the expecte-d after-tax and after-transactions dollar return on equity in market i XR7 as follows
ER7 = (l1-'re) Gi-O˘IECL1+ (l1-0d4l-?ua) EDY1- (l -r") C1 (4)
where
xi, e- e.,
The first term on the right hand side of (4) is the dollar capital gain net of U.S. taxes. The
second term reflects the foreign capital gains tax, adjusted for the U.S. credit. The expression
reflects that the U.S. Treasury taxes dollar capital gains, while the foreign treasury taxes capital gains
in its local currency. The third term is the dividend yield, net of U.S. and foreign taxes, again
adjusted for the tax credit. The final term is the net transaction costs, where transactions costs c* are
assumed to be deductible from U.S. income taxes.
6
Generally transactions costs c* in country i are a reflection of a number of country specific
factors. Specifically, let us assume that Cf are affected by a vector of country characteristics x1.
In the empirical work, the vector xf will consist of a range of country dummies, the rate of
inflation, a qualitative index of dividend repatriation restrictions, and linear and squared terms in the
(McAP/Y) I variable, which is the ratio of a country's equity market capital:zation to GDP. The
latter variable proves to be a good index of a country's equity market development. Transactions
costs C1 are related to the vector xl in the following straightforward linear fashion
ci=8x1 (5)
Combining (1), (4) and (5), the asset pricing relationship (1) can be restated in terms of pre-
tax equity returns as follows
RI -R= 31 (Rb-R) +40TAXCI +4dTADI +8X1 +q I (6)
where RI is the before-tax and before-transaction costs dollar return on equity market i
.,, is the before-tax, but after-transaction costs dollar return on the overall world portfolio
TAXC1 -VfCL1
TAXD1 t idDY
- T
e=-j_- u
103 d +@ fefC+dTd
7
The variables TAXCi and TAXw, are the per period foreign capital gains and dividend tax
burdens per dollar invested in equity market i. The parameters W, and Wd indicate the extent to which
the U.S. investor is compensated for these tax burdens by way of a higher pre-tax rate of return R1.
In deriving (6), use is made of the identity Ri=G,+DY1. Further, foreign taxes and corresponding
U.S. tax credits for the world portfolio are ignored.5 This implies that R.-R= (1 -'C.) (Rm-R) .
Finally, the world return R. is assumed to be a random variable with mean ER. and a random part
Cm'.
The foreign country capital gains tax base CL1 represents real capital gains as well as purely
inflationary gains. Hence, it is possible to divide CL, into separate real and nominal parts, denoted
CR1 and CNI, as follows
CL1mCRj1CNj (7)
with
CR.= efP~f,lP, l , (8)
XP11L2 el, .1
C77=Pi-pl, el,- (9)
In (8) and (9), P1 stands for country i's goods price index.6 The division of CL, into cR1
and CN1 allows us to estimate possibly different incidence rates of the foreign capital gains tax as
applied to strictly real and purely inflationary capital gains. CR1 and CN, are assumed to have
random components el' and el'. In particular, let 16, and Icn be the incidences of the capital gains
tax applied to real and inflationary gains for the U.S. investor (divided by 1 - .,,). After substituting
8
for CL, from (7) and allowing for different incidence parameters 9,r and Wc, (6) now can be restated
as follows
Ri-R-P3 (R.-R) +70,,TAXCR,4+8(TAYCN1 +OdTAXI +ja (10)
with
TAXCR1 ='rcCR1
TAXCNi ='OCN1
Section 4 presents the estimation results for both equations (6) and (10).
3. The data
The data set consists of monthly observations for the period January 1987 - April 1992 for 18
developing countries with emerging equity markets. The stock market data is from the Emerging
Markets Data Base constructed by the International Finance Corporation. The stock market returns
numbers are for market indices computed by the International Finance Corporation itself. These IFC
indices comprise a representative group of firms and are weighted by market capitalization.7 The
advantage of the IFC indices over local market indices is their consistency and comparability across
countries. The Appendix provides an account of data sources and variable definitions.
Information on mean stock market returns and other variables for each of the 18 countries is
given in Table 1. The variable R again is the dividend-inclusive monthly return in dollars, while G
just measures dollar capital appreciation. Foreign countries of course tax capital gains as
denominated in their own currencies rather than in dollars. The variable CL consequently measures
9
the part of the dollar return that is subject to the foreign capital gains tax. CR and CN are the parts
of CL that are due to real and purely inflationary capital gains (see the Appendix for algebraic
expressions of all derived variables).
The table shows that dollar rates of return for most countries have been very favorable during
the period. Argentina and Brazil in particular experience monthly dollar rates of return of around 9
and 5 per cent for the more than five year period. The domestic currency capital gains measure CL
and its inflationary part CN have been high as well, especially for the Latin American countries.
The capital gains related variables throughout are computed on the assumption that gains are realized
at the end of each month.
The variables TAXC, TAXCR, and TAXCN measure the monthly dollar tax burdens per
dollar invested associated with the capital gains tax base measures CL, CR and CN. The tax burden
TAXCN associated with merely inflationary capital gains is closely linked to the rate of inflation,
INF. The variable TAXD instead measures the monthly dollar tax burden per dollar invested
stemming from the witholding tax on dividends. This tax burden is small for most countries
compared to the capital gains tax liabilities.
The variable MCAP/Y stands for the market capitalization of a country's stock market as a
percentage of GDP. According to this measure, equity markets are most important in Malaysia, with
a MCAP/Y ratio of 0.91. This is similar to the ratio for the United States.8 Chile, Jordan, and
Korea, have relatively important stock markets as well, with market capitalization to GDP ratios close
to 0.5.
The variable r. is the capital gains withholding tax rate imposed on U.S. investors at the
beginning of 1991.9 The tax rates reflect the bilateral treaties between the U.S. and developing
countries where they exist. Most countries do not index their capital gains tax for inflation, and the
tax rates underlying the table apply to all nominal gains." The tax rate Td iS the dividend
10
withholding tax rate for a U.S. investor at the beginning of 1991. Only Mexico, Malaysia, Jordan
and Turkey are shown to refrain from taxing tax U.S. portfolio investment altogether. The tax rates,
if positive, tend to be higher than the (treaty) dividend tax rates imposed on U.S. investors by most
developed countries.
Summary data for the years 1987-1991 and all countries combined are given in Table 2. The
dollar return figures R and G confirm that for these years on average emerging stock markets have
performed very well. Interestingly, average market capitalizations as a percentage of GDP rose from
15.5 per cent in 1988 to 29.1 per cent in 1991. This development reflects the increasing importance
of equity markets in developing countries, as well as the generally large rates of appreciation during
the period. The average capital gains withholding tax rate is shown to be rather stable between 12
and 15 per cent. The average dividend witholding tax rate, however, has progressively declined from
around 20 per cent in 1988 to around 16 per cent in 1991.
4. Empirical results
This section presents tests of how dividend and capital gains taxes on non-residents affect the rates
of return on emerging stock markets. Each regression is first performed using ordinary least squares.
Equations (6) and (10), however, suggests the presence of heteroskedasticity across countries. To
correct for this, all equations are also estimated using weighted-least squares, with the OLS residuals
used to construct the weights.
Equations (6) and (10) are first estimated with the rate of dollar appreciation GI rather than
the dividend-inclusive return RI as the dependent variable. The reason is that the dividend-yield in
the data base can not be used for high inflation countries. The dividend yield is computed on a 12
month rolling basis, with a the domestic currency price index at the beginning of the 12-month
period. As a result, available dividend yields are unrealistically high for high inflation countries.
11
Table (3) presents the regression results. The OLS and weighted least squares regressions are
marked U and W respectively. All regressions allow for (unreported) country-specific pa parameters
and fixed effects. The world portfolio return is measured as the average of the dividend-inclusive
S&P 500 index and the Morgan Stanley world index. The risk-free dollar return R is approximated
by the 3-months U.S. T-bill rate. The inflation variable, INF, is included in the regression to test for
an inflationary impact on equity returns independently of its implications for an investor's capital
gains tax liability. All regressors reported in the table apart from INF are lagged a month to
account for endogeneity. The regressions in columns (1)-(4) are in terms of actual returns, while
column (5) is in terms of excess returns.
The regressions in column (1) represent the base case of equation (10) minus the TAXD
variable. The results first indicate that the stock market return is related negatively to MCAP/Y,
which suggests that the costs of investing in a country's equity market decline with its market
size/GDP ratio. The estimated coefficient of -0.125 for the MCAP/Y variable implies that an
increase in the stock market capitalization/GDP ratio by one reduces the required monthly dollar
return by 0.125 per cent, and the annual return by 1.5 per cent. This empirical relationship could
reflect that a more sizable stock market - relative to GDP - results in higher liquidity and lower
trarsaction costs. The relationship can also be a reflection of cross-country variation in disclosure or
other rules that affect an investor's costs in gathering information and protecting his investments.
Some alternative indicators of equity market development such as qualitative information
regarding the quality of accounting standards, the existence of a government agency concentrating on
regulating market activity and the extent of investor protection generally proved not to significantly
affect stock market returns."1
The IF and Oc, parameters are estimated at around 0.3 and 1.0 respectively. To arrive at the
underlying incidence rates O, and O,,n, these numbers have to be multiplied by 1 s-, or roughly 2/3.
12
The resulting figures of 0.2 and 0.66 respectively indicate the foreign investor has to be partially
compensated by way of higher equity returns for capital gains taxes paid abroad. At least partial
compensation is consistent with the absence of offsetting tax credits provided by the U.S. and other
developed country treasuries.
Unlike the model of section 2, the investor operates in a multi-period world. As a result, two
difficulties arise in interpreting the estimates of Ocr and 0,,n coefficients as incidence shares that do
not emerge in a single period world. First, the investor's asset holding period does not necessarily
correspond to a month. Hence, the estimated coefficients on the TAXCR and TAXCN variables
more closely correspond to the increase during the month in the present value of the capital gains tax
to be paid at some time in the future. Clearly the present value of a tax to be realized at some time
in the future is less than its present value if paid today. If follows that the deferment of capital gains
taxes lowers the estimated coefficients, regardless of the actual incidence rates. A second difficulty is
that the estimated coefficients may also reflect additional information obtained during the month on
tax liabilities to be incurred in the future. For instance, higher inflation today may generally imply
higher inflation tomorrow. If so, the coefficient on the TAXCN variable reflects the tax burden
associated with a higher capital gains liability incurred today as well tomorrow. Persistence in
inflation hence occasions a larger coefficient iF. during an initial inflationary period. The first
difficulty in interpreting the results may be more systematic than the second. Hence, the estimated
incidence rates on the domestic economy, as represented by O and 0d' probably underestimate the
true incidences.
The DIVREST variable is a dummy variable that equals one if the country imposes any
restrictions on the repatriation of dividends, and it is zero otherwise. The variable enters the
regression negatively, which suggests these restrictions lower the pre-tax return on equity. A possible
reason is that repatriation restictions force investors to remain invested in the country *, a larger
13
extent than is desirable. Trapped dividends may then have to be invested in low return projects,
which explain the negative relationship between equity returns and repatriation restrictions.
Finally the negative coefficient on the INF variable suggests that inflation lowers the return on
equity for reasons independent of the capital gains taxes.
Initial advances in equity market development, as proxied by an increasing MCAP/Y variable
from an initial low level, should be expected to lower the required return considerably. However,
one expects the relationship between the MCAP/Y variable and equity returns to become less
pronounced at higher levels of stock market development. To test this hypothesis, the regressions in
column (2) include a squared term in the MCAPNY variable. The positive estimated coefficient is in
support of the hypothesis. The linear and squared MCAP/Y coefficients together suggest that with
MCAP/Y = 0 at the margin an increase in MCAP/Y lowers the required rate of return about twice as
much as at MCAPIY = 0.5.
The regressions in column (3) more closely corresponds to equation (6). It has a single tax
burden TAXC associated with the capital gains tax. The estimated coefficient is 0.337, in between
the coefficients on the TAXCR and TAXCI variables in previous regressions.
As mentioned, it is generally unclear when (if ever) a foreign investor will repatriate his intial
investment along with accumulated capital gains. The assumption so far that all capital gains are
realized each month clearly is an extreme assumption. At the other extreme, one can assume that
capital gains never are realized. In that case all returns, present and future, will be repatriated as
dividends. For this case, the dividend tax burden can be approximated as if the capital gains during a
period were in fact paid out as dividends in that period. This procedure is correct if a capital gain
represents the exact increase in the present value of future dividends during the period, and if the
dividend tax withholding tax were not to change over time. For this case, the TAXR variable
represents the present value of all the dividend tax liability incurred during the period. The
14
coefficient on the TAXR variable in the unweighted regression in column (4) is positive but
insignificant. It is somewhat larger and significant in the weighted regression.
Finally in column (5) the dependent variable is taken to be the excess return on a developing
country stock market, measured as the rate of appreciation of the IFC dollar index minus the 3-
months U.S. T-bill interest rate. In other respects the regressions are as in column (2). The overall
results are very similar to those reported before.
Table 4 presents regression results where the dependent variable is the dividend-inclusive
dollar return. The sample now excludes the Latin American countries, as the dividend yield reported
is distorted for high inflation countries. The regressions now include the TAXD variable. Otherwise
they are as those in Table 3. Column (1) first shows that the estimated coefficient I,,, now equals
3.518, which is much larger than before. A reason may be that at lower levels of inflation, an
increase in inflation is more of a signal of future inflation. A second reason is that in low inflation
countries investors are more likely to actually pay the capital gains tax at some point, while in high
inflation countries the capital gains tax may prohibit selling to ever occur. Thus in high inflation
countries assets may be completely locked in, with capital gains never realized. In this environment,
higher inflation has little impact on the future real capital gains tax burden.
The TAXD variable enters with a positive but insignificant coefficient throughout, in contrast
to the coefficients on the capital gains tax burden variables TAXCR and TAXCN. A reason for the
insignificant coefficient for the TAXD variable may be that the non-resident investor generally can
obtain an off-setting tax credit for dividend withholding taxes paid abroad. Also note that the INF
variable is no longer significant. Other regressions in the table are modified in similar ways. The
TAXC and TAXR variables, however, are now significant throughtout.
5. Conclusion
15
This paper has examined to what extent features of the international tax system and indicators of
transaction costs affect the required rates of return on emerging stock markets. The capital gains
withholding tax levied on foreign portfolio investors is shown to increase pre-tax required rates of
return. As countries generally do not index their capital gains taxes, it follows that inflation increases
the capital gains tax base, and also the required rate of return on equity. Dividend withholding taxes
instead appear not to s:gnificantly increase pre-tax equity returns. The differing results for capital
gains and dividend taxes reflect the fact that foreign investors generally can receive domestic tax
credits only for foreign withholding taxes paid on aividends.
The return on equity is part of the issuing firm's cost of capital. Hence, capital gains
withholding taxes imposed on non-residents increase the cost of capital for domestic firms, and
discourage physical investment. Private sector investment levels have tended to be low in developing
countries in the 1980s. The cost of equity finance in developing countries has gained in importance
in the last decade, as these countries' access to international lending capital has been limited during
most of the decade.
The results of this paper have immediate implications for the design of tax policy related to
foreign portfolio investment in developing countries. The existence of foreign tax credits for dividend
taxes paid suggests a country should tax capital gains lightly in comparison to repatriated dividends.
This is the policy pursued by Greece, Pakistan, Portugal and Venezuela. Each of these countries has
positive dividend withholding taxes but no capital gains taxes imposed on non-residents. Colombia
and India, however, do the exact opposite: they tax capital gains heavily compared to dividends.
Contrary to what appears optimal, the trend in developing countries is towards lower dividend
withholding taxes according to Table 2, with little change in the average level of capital gains
taxation. Also, it appears desirable for developing countries to index their capital gains taxes to
prevent them from being higher than anticipated.
16
While developing countries may not have eliminated the taxation barriers to foreign portfolio
investment, they have taken steps to improve overall foreign access to the domestic equity market in
other important ways. Some countries have encouraged foreign equity participation through debt
equity swaps, and through the establishment of country equity funds. Also, foreign ownership
restrictions and repatriation restrictions on dividend and capital returns have generally been relaxed
over the last decade.
The result that capital gains taxes increase the required pre-tax return on portfolio investment
in emerging equity markets should hold equally for developed countries. Hence, a capital gains tax
cut for U.S. equities (rather than U.S. citizens) can be expected to lower the required rate of return
on U.S. equities, with a concomittant reduction in the cost of capital of U.S. firms."2 It is probably
impossible, however, to infer the impact of capital gains taxes on equity returns for a single country,
as there may be too little variation in the capital gains tax rate. For the developed countries as a
whole, however, tests similar to those in this paper should be possible.
Apart from taxes, there are other costs to investors associated with investments in a particular
country for which they need to be compensated. A country's market capitalization to GDP ratio is
shown to be a good indicator of these costs. In particular, the equity return in a country is negatively
related to the equity market's market capitalization to GDP ratio. The data, however, do not reveal
whether this relationship is due to variation in direct transactions costs or whether a high market
capitalization/GDP ratio reflects favorable equity market practices in the form of disclosure and other
rules and regulations.
17
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18
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19
Endnotes
1. The limitations of this assumption for the empirical work are discussed in section 4.
2. In addition, interest is not taxed and cannot be expensed abroad. These assumptions sidestep existing
national rules for allocating interest expense to different income sources.
3. U.S. foreign tax credits can only be used to offset U.S. taxes on foreign source income in the same income
basket.
4. The securities that comprise an equity market are taken to be a single asset. Hence, this paper abstracts
froca selective investments in foreign equity markets.
5. This is because it is difficult to accurately compute the appropriate withholding tax rates. Similarly,
transaction costs associated with holding the market portfolio are ignored in the empirical work.
6. In the empirical work, Pi is taken to be the consumer price index.
7. For information on the method of construction of the IFC indices, see the Emerging Stock Markets Factbook
1991, pp. 78-79.
8. The value of U.S. corporate stock at the end of 1987 was 4,315 billion dollars, while U.S. GDP for 1987
was 4,497 billion, with a ratio of 0.96.
9. Capital gains tax rates for domestic residents display a close correlation with those imposed on foreign
residents. Nigeria, for instance, has a flat capital gains tax of 20 per cent imposed on residents as well as non-
residents. A number of countries, such as Brazil, Chile, Mexico, Venezuela, India and Korea tax capital gains
as ordinary income, and hence the marginal tax rate depends on the person's income level. Chile and Mexico
allow for adjustments of capital gains for inflation. Colombia and Turkey distinguish between short term (less
than 2 and 1 years respectively) and long term capital gairs. Short term capital gains are counted as ordinary
income, while long term capital gains are taxed at a lower rate. Argentina has no capital gains tax for
marketable securities for residents, even though it taxes capital gains accruing to foreign residents. Malaysia,
Portugal and Greece do not tax domestic capital gains. Sources: latest country guides of the 'Doing Business
in ..' series of Price Waterhouse.
10. This means that capital gains withholding tax rates for Argentina and Chile for the years 1990-1991 and
1987-1989 respectively in which only inflation-adjusted capital gains were taxed are excluded.
11. These unreported results only demonstrate that these additional indicators of market development do not
affect returns on financial capital. The results, however, do not rule out that the indicators are related to the
returns on physical investment if they in part reflect the cost structure of the firm.
12. Of course, the relationship between the capital gains tax and equity returns is only one aspect of a larger
debate that includes the overall distributive implications.
20
Table 1. Emerging Stock Markets - Descriptive Statistics by Country.
Counuty R G CL CR CN INF TAXC TAXCR TAXCN TAXD MCAPIY ef- $|
Latin America
Argentia .094 .094 .206 .055 .178 .246 .086 .024 0.44 .000 .019 36 17.5
Brazil .053 .053 .229 .039 .186 .240 .018 .006 .009 .000 .080 25 25
Chile .041 .036 .043 .027 .015 .015 .012 .007 .002 .0018 .449 10 10
Colombia .031 .027 .047 .027 .021 .021 .012 .008 005 .0006 .033 30 0
Mexico .052 .050 .057 .034 .022 .022 .000 .000 .000 .0004 .127 0 0
Venzuela .036 .035 .050 .024 .032 .032 -.000 .000 .oDo .0001 .081 0 20
Asia
India .029 .028 .042 .022 .008 .008 .013 .009 .003 .0004 .110 40 25
Indonesia -.018 -.012 -.008 -.023 .008 .006 ,.002 -.005 .002 .000 .059 20 20
Korea .005 .004 .003 -.001 .006 .006 -.001 .000 .000 .0002 .444 0 25
Malaysia .016 .014 .014 .011 .003 .003 .000 .000 .000 .0003 .931 0 0
Paista .024 .019 .026 .023 .008 .008 .000 .000 .000 .0007 .074 0 15
Thailand .020 .017 .018 .011 .004 004 .002 .000 .001 .0006 .259 25 20
Eu1rApfideast/Acfiica
Greece .018 .015 .023 .009 .013 .014 .003 .D1 .002 .0014 .128 0 42
Jordan .002 -.002 .010 -.002 .011 .012 .000 .000 .000 .000 .507 0 0
Nigeria .008 .003 .027 .007 .023 .024 .005 .001 .005 .0009 .035 20 15
Portugal -.006 -.008 -.007 -.017 1oo9 .009 .000 .000 .000 .0004 .174 0 25
Turke 1 -.009 -.012 .023 -.013 .042 .043 .004 .003 .001 .0003 .091 0 0
rZimbabwe l.002 -.003 .019 .014 .014 .014 .006 .004 .004 .0009 .205 30 I 20
For varibles R, G, CL, TAXC, and TAXD the reported values ae mea for the period 1988-1992. For f and 7s 1991 values ar reported. The means for the rest of the variables do no iachWle 1992
obServationS. Variable definitions and sources are given in the Appendix.
Table 2. Emerging Stock Markets - Descriptive Statistks by Year.
1988 1989 .990 1991
R .013 .043 .018 .030
0 .016 .039 .009 .028
CL .037 .074 .035 .049
CR .002 .030 .002 .025
CN .032 .043 .038 .023
INF .034 .056 .045 .025
TAXC .006 .016 .006 .011
TAXCR .001 .007 .000 .006
TAXCN .004 .008 .002 .003
TAXD .001 .001 .001 .000
MCAP/Y .155 .199 .229 .291
__ 12.237 13.289 14.778 13.111
7A _ q 20.033 19.612 21.700 15.528
Reported are the yearly mean values for the countries in the sample (see Table 1). Variable definitions and sources
are given in the Appendix.
22
Table 3. Rate of Return Regressions for Emerging Markets - Excluding Dividends.
(1 ( O3) (4) (5)
I______ _ U_ W I U W U W-_ U w u w
MCAPY -.126-.119 -.341 -.340** -.32 -.328*0 -.325*0 -.317*2 -.3380
(.053) (.016) (.19) (.030) (.120) (.033) (.120) (.037) (. I^0) (.038)
(MCAP/Y)P .176* .175** .170t .169" .167# .162" .136J .156"
(.087) (.022) (.087) (.023) (.088) (.026) (.087) (.025)
TAXCR .291# .2780 .302Q .292** .320* .338"
(.159) (.007) (.159) (.066) (.160) (.074)
TAXCN 1.049w 1.055* 1.060 0 1.062* .9899* 1.018"
(.312) (.157) (.312) (.154) (.313) (.152)
INP -.1630 -.1140 -.163" -. 1 15+* -.120# -.096* -.035 -.017 -.1810 -.092#
(.063) (.044) (.062) (.042) (.063) (.031) (.053) (.038) (.063) (.048)
TAXC .350o .337*
_____________ ____________ (.134) (.060)
TAXR .117 .193*
(.163) (.061) _
DIVREST -.049" -.048' -.0560 -.057** -.047" -.050" -.045" -.047" -.055 -.060"
(.016) (.006) (.017) (.006) (.016) (.005) (.017) (.006) (.017) (.006)
NO OBS. 810 |
| R2 .11 | .48 | .11 .65 .10 .67 .09 .49 .11 .49
The dependent variable is G, the dollar rate of return, in specifications 1-4, and the excem rat of return in the last specification. Rate of rturn is defined as the percentage change in
the dollar price index and does not include dividends. Not repored above are country dummy variables. Regresions also include the world rate of return (execss return in specification 5),
with a coefficicat that is alowed to vay across ountries. All reported gresors other than I ar lagged one month. Columns U and W report OLS and weighted-OLS reilts of the same
specification, where the reiduals of the OLS regression are used to construct the weights. Standard errors are given in parenthese. 0, * , Ia # indicate that the coefficient is
significantly different from zero at 1, 5, and 10 percent levels respectively. Variable definitions and sources ar given in the Appmdix.
Table 4. Rate of Return Regressions for Emerging Markets - Including Dividends.
(1) (2)T (3) (41 (5)
MCAPIY -.1S3"* -.146*0 -.458*0 -.443** -.443** -.422*0 -.444*0 -.415*0 -.417?" -.409*0
(.043) (.012) (.095) (.036) (.096) (.035) (.094) (.038) (.096) (.0377)
(MCAP/yp .230*0 .221'0 .2220 .209** .223** .208*0 .206*' .194*
_ (.064) (.023) (.065) (.021) (.064) (.5) (.064) (.024)
TAXCR .6040 .5730* .620-5 .6360 _ .578** .6410
(.239) (.115) ((.236) (.130) (235) (.133)
TAXCN 3.5190 3.107* 3.754** 3.1560* 3.732" 2.5040
(1.271) (.502) (I.257) (.666) (1.257) (.645)
I>.P~~ -.177 -.141# -.135 -.098 -.053 -.055 -.055 -.066 -.133 -.033
_____________ (.243) (.087) (.240) (.088) (.239) (.080) (.239) (.080) (.247) (.103)
TAXD 3.560 2.958 .531 .780 -.182 .511 .526 2.023
(5.367) (2.347) (5.373) (1-293) (5.394) (2.118) (5.385) (2172)
TAXC .6660 .71500
______________ ____________ ___________ _ _______ _ - (_233) (.118) ___________ _ _______3
TAXR .481 .4330
(.176) (.093)
DIVREST -.057" -.054- -.065" -.0630 -.065* -.064" -.0627 -.060" -.065* -.0650
(.014) (.006) (.014) (.005) (.014) (.004) (.014) (.005) (.014) (.005)
NO OBS. 514
R2 . IS .59 .17 .60 .16 66 .16 .84 17 56
The dependent vaiable is R, the rabt of return, in specifications 1.4, and ER, excss rate of retrim in the hast specification. Not reported above ar country dummy variables.
Regreaion also inchde the world rae of reatrn (exess return in specification 5), with a coefficient that is allowed to vary across countries. All reponed regesrs apart
from INF are lagged one moth. The sample excludes Laun American countries. Columns U and W report OLS and weighted-OLS results of the same specification, where the resuals
of the OLS regresion are used to construct the weights. Stndsrd erors are given in paretheses. , 0 and 1 indicate that the coefficient is significantly d;fferent from zero
at 1, 5 and 10 percent levels, respectively. Variable definitions and sources are given in the Appendix.
Appendix: Variable Definitions and Sources
Basic variables:
1n: Foreign currence IFC equity market index
Di: Foreign currency dividend return on IFC index
PI: Foreign price index at end of period
el: Exchange rate expressed as dollars per unit of foreign currency
r. Capital gains withholding tax rate for U.S. investors
d
Dividend withholding tax rate for U.S. investors
MCAP1: Equity market cap.Walization in foreign currency
YI: GDP in foreign currency
b
R;: World portfolio return in dollars, computed as average of S&P 500 and the Morgan
Stanley world index
it: Risk-free rate of return in U.S. dollars measured as 3-month U.S. T-Bill rate
DIVEST: Dummy variable equal to one if the country in any way restricts the repatriation of
dividends, and zero otherwise
Derived Variables:
Ij Di -1:
Dividend inclusive dollar return on equity market i
Gj= ^ -1:
Rate of appreciation of dollar price index of market i
25
ER,=R,-R:
Dollar dividend-inclusive excess return on equity market i
INFi= 1=
Pi_,
Rate of inflation
1~',-1 e,1
Part of the dollar return on equity market i that is subject to capital gains tax in country i
CR,= l and CN,=INFi e
It4-1/P4- eI C e l-
Parts of CL, that are due to real and purely inflationary capital gains in country i
TAXC,=4, *CL,:
Capital gains tax in dollars assessed per dollar invested in country i
TAXCR4=1, *CR, and TAXCNj='r *CN:
Parts of TAXC, due to real and purely inflationaly capital gains
DYI=, De
Dollar dividend yield
TAXD,=*d*DY,:
Dividend tax in dollars assessed on U.S. investor per dollar invested in country i
TAXR,=4d *R,:
Dividend tax in dollars assessed on U.S. investor per dollar invested if all returns were
repatriated as dividends
Data Sources:
26
Ip,DpcepMCAP,:
Emerging Markets Data Base, International Finance Corporation
Pi, Yp R:
International Finance Statistics, International Monetary Fund
c d
Tj, jDIlSTj:
Emerging Stock Market Facts Book, International Finance Corporation, various issues
b.
Morgan Stanley, and Standard and Poor
27
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